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Saturday, March 14, 2009

Galbraith on financial bubbles and busts

In 1999, John Kenneth Galbraith explained how to spot speculative excess:

Notable and Quotable, WSJ: From an address given by John Kenneth Galbraith at the London School of Economics in June 1999 called "The Unfinished Business of the Century":

We have far more people selling derivatives, index funds and mutual funds (as we call them) than there is intelligence for the task. I am cautious about prediction; I discovered years ago that my correct predictions are forgotten, the others meticulously remembered. But some things are definite; when you hear it being said that we have entered a new economy of permanent prosperity with prices of financial instruments reflecting that happy fact, you should take cover. This has been the standard justification of speculative excess for several centuries -- for a good part of the millennium. My one-time Harvard colleague Joseph Schumpeter thought inevitable and even beneficial what he called "creative destruction" -- the cyclical process by which the system eliminates the people and institutions which are mentally too vulnerable for useful economic service. Unfortunately the process has larger and less benign effects, including the possibility of painful recession or depression.

LSE has a full transcript of the 1999 lecture here (pdf). In fact, now that I'm skimming it, I think it's worth quoting what Galbraith said prior to the passage above:

The most serious [problem within economies] is the ancient and unsolved problemof instability – of the enduring sequence of boom and bust. The history goesback for centuries to the Tulipmania in Holland in 1637 and perhaps before, tothe early eighteenth century promise in Paris of gold in Louisianna – gold notyet discovered – and here to the South Sea Bubble. (In later years there was awonderful prospect for draining the Red Sea to recover the treasure left behindat the crossing of the Isrelites.) In the century, in the United States, aboutevery 30 years there was a sequence of boom and bust, including the Great Crashof 1929. The speculative crash, now called a correction, has been a basicfeature of the system. In the United States we are now having another exercisein speculative optimism following the partial reversal last year.

And also what Galbraith said immediately after noting that the "possibility of painful recession or depression":

Let us not assume that the age of slump, recession, depression is past. Let ushave both the needed warnings against speculative excess and awareness that theensuing slump can be painful. And there will then be need for specific remedialaction by the government. Keynes, one regularly reads, is out of fashion; his isa cyclical legacy that fades in good times, returns with recession.